1 chapter 10 an overview of stabilization programs © pierre-richard agénor and peter j. montiel
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1
Chapter 10An Overview of Stabilization
Programs
© Pierre-Richard Agénor and Peter J. Montiel
2
High inflation is more common among developing countries than in the industrial world.
Table 10.1: Summarizes major inflation episodes in developing
countries during the period 1980-1996. Instances of high inflation are found in Africa, Asia, and
the Middle East, and in the Western Hemisphere. Small group of countries appear to have suffered from
“chronic” high inflation. This group includes Argentina, Bolivia, Brazil, Chile,
Ecuador, Ghana, Guyana, Israel, Mexico, Paraguay, Peru, Turkey, Uruguay, and Zaire.
3
Variety of approaches have been used to stabilize high inflation: populist; orthodox (money-based and exchange-rate-based); heterodox.
Populist programs focuses on direct intervention in the wage-price process through wage and price controls.
Orthodox programs: They feature an intended fiscal adjustment.
Two varieties: Money-based programs rely on restrictions on the rate
of monetary expansion to provide a nominal anchor. Exchange-rate-based programs rely on exchange-rate
pegging to provide the nominal anchor.
4
Speed of implementation: “Cold turkey” or “shock therapy”:desired fiscal
adjustment is implemented in one-step fashion. “Gradualist”: place the fiscal deficit on a declining path.
Heterodox program: Fiscal correction, an exchange-rate freeze or a
preannounced exchange-rate path. Incomes policies in the form of either explicit wage-price
controls or a “social contract.”
5
Populism. Orthodox Money-Based Stabilization. Exchange-Rate-Based (Southern Cone). Heterodox Programs. Argentina’s Convertibility Plan (1991-1997). Brazil’s Real Plan (1994-1997). Lessons of Stabilization.
Populism
7
Best-known instances of populism have been in Latin America.
Populism did not evolve as an approach to the stabilization of high inflation.
They were aimed at a broader range of macroeconomic problems, including stagnant production, unequal income distribution, external crises, high inflation.
Populist programs to be discussed have attempted to combine rapid growth with low inflation; pursue stimulative aggregate demand policies;
8
restrain wage and price increases through administrative controls.
Populist diagnosis is based on the view that the economy possesses unutilized productive capacity, due both to deficient aggregate demand and to monopoly power in the manufacturing sector.
Reasons for deficient demand: restrictive aggregate demand policies; unequal distribution of income.
Remedy: expansionary fiscal policies and rising wages. Although profits may be depressed by the increase in
labor costs, price increases are not necessary.
9
Reason: total profits would be increased by the expansion in output.
To ensure that prices do not rise, administrative controls are the favored policy tool.
Two examples: Chile under Allende (1970-1973). Peru under García (1986-1990).
10
Chile under Allende (1970-1973) Figure 10.1.
11
Source: Dornbusch and Edwards (1990, p.260) and IMF.
Figure 10.1aChile: Macroeconomic Indicators, 1970-73
(In percent, unless otherwise indicated)
1970 1971 1972 1973
-15
-10
-5
0
5
10
15
0
-151970 1971 1972 1973
0
100
200
300
400
500
600
700
00
Inflation
Broad money growth
Base money growth
Real GDP growth rate
Private consumption growth
Real investment growth
12
Source: Dornbusch and Edwards (1990, p.260) and IMF.
Figure 10.1bChile: Macroeconomic Indicators, 1970-73
(In percent, unless otherwise indicated)
1970 1971 1972 1973
0
10
20
30
40
50
00 -30
-25
-20
-15
-10
-5
0 In percent of GDP
1970 1971 1972 197370
80
90
100
110
120
130
100
70
Real wage (1970q3 = 100)
Government revenue(left scale)
Government spending(left scale)
Fiscal balance(right scale)
13
Peru under García (1986-1990) Figure 10.2.
14
Source: Cardoso and Helwege (1992, p. 209), and Caceres and Paredes (1991, p. 85) and IMF.
1985 1986 1987 1988 1989
-15
-10
-5
0
5
10
15
20
-15
Figure 10.2aPeru: Macroeconomic Indicators, 1985-89
(In percent, unless otherwise indicated)
1985 1986 1987 1988 1989
0
500
1000
1500
2000
2500
3000
0
Inflation
Base money growth
Broad money growth
Real GDP growth rate
Private consumption growth
15
Source: Cardoso and Helwege (1992, p. 209), and Caceres and Paredes (1991, p. 85) and IMF.
1985 1986 1987 1988 1989
30
40
50
60
70
80
90
100 Real wage (1970 = 100)
Figure 10.2bPeru: Macroeconomic Indicators, 1985-89
(In percent, unless otherwise indicated)
1985 1986 1987 1988 1989-12
-9
-6
-3
00
-12
Current account balance(in percent of GDP)
Nonfinancial public sector balance(in percent of GDP)
Orthodox Money-Based Stabilization
17
This approach emphasize on demand management without using direct wage-price controls or guidelines.
Sine qua non of orthodox stabilization is fiscal adjustment.
Note that central bank credit to the public sector is the most important source of base money creation in developing countries.
Balance of payments and credit extended to the private sector are alternative sources.
Thus fiscal adjustment that limits the public sector's call on central bank resources does not necessarily imply that the money stock will stop growing.
This means that fiscal adjustment does not, by itself, imply the use of money as a nominal anchor.
18
However, fiscal adjustment is necessary for the sustained achievement of money growth rates compatible with low inflation and public sector solvency.
Orthodox money-based programs rely on a money growth target as a nominal anchor feature fiscal adjustment.
Two best-known applications: Chile (September 1973). Bolivia (August 29, 1985).
19
Chile (September 1973) Figure 10.3.
20
Source: Kiguel and Liviatan (1988, p. 289) and IMF.
Figure 10.3aChile: Macroeconomic Indicators, 1973-77
(In percent, unless otherwise indicated)
1973 1974 1975 1976 1977-15
-10
-5
0
5
10
15
0
-151973 1974 1975 1976 1977
0
100
200
300
400
500
600
700
0
Inflation Devaluation rate
Real GDP growth rate
Private consumption growth
Base money growth
21
Source: Kiguel and Liviatan (1988, p. 289) and IMF.
Figure 10.3bChile: Macroeconomic Indicators, 1973-77
(In percent, unless otherwise indicated)
1973 1974 1975 1976 1977-30
-25
-20
-15
-10
-5
0
5
-30
1973 1974 1975 1976 1977
60
65
70
75
80
85
60
Real wage (1970 = 100)
Fiscal balance(in percent of GDP)
Current account balance(in percent of GDP)
22
Source: Kiguel and Liviatan (1988, p. 289) and IMF.
Figure 10.3cChile: Macroeconomic Indicators, 1973-77
(In percent, unless otherwise indicated)
1973 1974 1975 1976 1977
80
85
90
95
100
105
110
100
80
Real effective exchange rate (1975q3 = 100)
1973 1974 1975 1976 1977
50
60
70
80
90
100
50
Terms of trade (1970 = 100)
23
Bolivia (August 29, 1985) Figure 10.4.
24
Source: Fiscal data are from Sachs (1986) and IMF. All other data are from Kiguel and Liviatan (1988, p. 275).
Figure 10.4aBolivia: Macroeconomic Indicators, 1979-86
(In percent, unless otherwise indicated)
1980 1982 1984 19860
2,000
4,000
6,000
8,000
10,000
12,000
14,000
0
Base money growth
Broad money growth
Inflation
1980 1982 1984 1986-15
-10
-5
0
5
10
0
-15
GDP growth rate
Private consumption growth
25
Source: Fiscal data are from Sachs (1986) and IMF. All other data are from Kiguel and Liviatan (1988, p. 275).
Figure 10.4bBolivia: Macroeconomic Indicators, 1979-86
(In percent, unless otherwise indicated)
1980 1982 1984 1986
0
5
10
15
20
25
30
35
0 -40
-30
-20
-10
0
10 Central government (in percent of GDP)
1980 1982 1984 1986
80
85
90
95
100
105
100
80
Terms of trade (1980 = 100)
Governmentexpenditure
Government revenue
Fiscal balance(right scale)
Exchange-Rate-Based (Southern Cone)
Stabilization Programs
27
Failure of orthodox stabilization to reduce inflation in chronic high-inflation countries led to adoption of alternative approach in the Southern Cone countries during the late 1970s.
Intellectual foundation for this approach: monetary approach to the balance of payments (MABP).
Important tenet of the monetary approach: belief that PPP held more or less continuously.
Thus, domestic price level would be determined by the exchange rate.
Thus, inflation stabilization required slowing the rate of depreciation of the exchange rate.
Then external balance would be achieved by restrictive aggregate demand policy.
28
Output growth was taken to depend on domestic supply conditions.
It could therefore be promoted by undertaking market-oriented structural reforms.
Complete package included predetermined exchange-rate path; fiscal and structural adjustment.
Trade liberalization had an important role. Reason: adoption of low and uniform tariffs promotes
economic growth, and supports the price stability objective through the influence of the law of one price.
29
Examples: Chile (February 1978). Uruguay (October 1978). Argentina (December 1978).
30
Chile (February 1978) Figure 10.5.
31
Figure 10.5aChile: Macroeconomic Indicators, 1977-82
(In percent, unless otherwise indicated)
Source: Végh (1992, pp. 680-81).
1978q1
1980q1
1982q1
-20
-15
-10
-5
0
5
10
15
-20-20
Real GDP growth rate
1978q1
1980q1
1982q1
0
10
20
30
40
50
60
70
80
90
100
0 0
100
200
300
400
Devaluation rate(right scale)
Inflation(left scale)
32
Figure 10.5bChile: Macroeconomic Indicators, 1977-82
(In percent, unless otherwise indicated)
Source: Végh (1992, pp. 680-81).
1978q1
1980q1
1982q1
-6
-5
-4
-3
-2
-1
0
1
2
3
0
-6
Fiscal balance (in percent of GDP)
1978q1
1980q1
1982q1
0
50
100
150
200
250
300
0
Nominal lending rate
33
Figure 10.5cChile: Macroeconomic Indicators, 1977-82
(In percent, unless otherwise indicated)
Source: Végh (1992, pp. 680-81).
1978q1
1980q1
1982q1
60
70
80
90
100
110
120
130
140
60
100
1978q1
1980q1
1982q1
-600
-500
-400
-300
-200
-100
0
100
200
300
400
-600-600
Trade balance (in millions of U.S. dollars)
Real wage(1978 = 100)
Real effective exchange rate(1978 = 100)
34
Uruguay (October 1978) Figure 10.6.
35
Figure 10.6aUruguay: Macroeconomic Indicators, 1978-82
(In percent, unless otherwise indicated)
Source: Végh (1992, pp. 682-83).
1978q1 1979q1 1980q1 1981q1 1982q10
10
20
30
40
50
60
70
80
90
0
Nominal devaluation rate
Inflation
1978q1 1979q1 1980q1 1981q1 1982q1-20
-15
-10
-5
0
5
10
15
-20-20
Real GDP growth rate
36
Figure 10.6bUruguay: Macroeconomic Indicators, 1978-82
(In percent, unless otherwise indicated)
Source: Végh (1992, pp. 682-83).
1978q1 1979q1 1980q1 1981q1 1982q1
-10
-8
-6
-4
-2
0
2
0
-10
Fiscal balance (in percent of GDP)
1978q1 1979q1 1980q1 1981q1 1982q1
45
50
55
60
65
70
75
80
45
Nominal lending rate
37
Figure 10.6cUruguay: Macroeconomic Indicators, 1978-82
(In percent, unless otherwise indicated)
Source: Végh (1992, pp. 682-83).
1978q1 1979q1 1980q1 1981q1 1982q1
50
60
70
80
90
100
110
50
100
1978q1 1979q1 1980q1 1981q1 1982q1
-250
-200
-150
-100
-50
0
50
100
-250
Trade balance (in millions of U.S. dollars)
Real effective exchange rate (1978 = 100)
Real wage(1978 = 100)
38
Argentina (December 1978) Figure 10.7.
39
Source: Fernández (1985) and IMF.
Figure 10.7aArgentina: Macroeconomic Indicators, 1976-82
(In percent, unless otherwise indicated)
1976 1977 1978 1979 1980 1981 1982
0
100
200
300
400
500
600
700
800
0 0
10
20
30
40
1976 1977 1978 1979 1980 1981 1982
2
2.5
3
3.5
4
4.5
5
5.5
95
100
105
110
115
120
125Inflation (left scale)
Nominal lending rate(right scale)
Base money growth(left scale)
Unemployment rate
Real wage(right scale, 1976=100)
40
Source: Fernández (1985) and IMF.1/ The real exchange rate is defined as the export price index over the index of prices of nontradables.
Figure 10.7bArgentina: Macroeconomic Indicators, 1976-82
(In percent, unless otherwise indicated)
1976 1977 1978 1979 1980 1981 1982
-20
-15
-10
-5
0
5
0
-20
1976 1977 1978 1979 1980 1981 1982
30
40
50
60
70
80
90
100
110
100
Public sector balance(in percent of GDP)
Current account balance(in percent of GDP)
Real exchange rate (1975=100) 1/
Heterodox Programs
42
Since inflation has a strong inertial component, even if “fundamentals” are corrected, inflation would continue at high rates.
Thus, restrictive aggregate demand policies with correction of the fiscal and monetary fundamentals would result in a deep and prolonged recession.
Such a recession would entail economic and political costs, and call into question the authorities' commitment to persevere in the anti-inflation effort.
Inertia may arise from two sources: existence of explicit or implicit backward-looking
indexation in nominal variables; initial lack of credibility.
Heterodox programs were undertaken by several developing nations in the mid- to late 1980s.
43
Examples: Argentina (December 1978). Israel (July 1, 1985). Brazil (February 28, 1986). Mexico (December 1987).
Similarities: These are all middle-income developing countries,
except Argentina. They had enjoyed considerable economic success
during the 1960s and 1970s. Stabilization effort was launched under what amounted
to a new political regime that took power after a period of economic and political crisis.
44
Inflation accelerated in the first half of the decade and had reached triple-digit levels by the time the attempted stabilization was undertaken.
They had disappointing growth performance during the early 1980s.
They confronted severe external imbalances associated with the international debt crisis.
They enjoyed initial success, in that they achieved a substantial reduction in inflation without severe costs in terms of reduced economic activity.
Yet only the Israeli and Mexican programs are currently considered to have achieved enduring success.
45
Argentina (June 14, 1985) Figure 10.8.
46
Figure 10.8aArgentina: Macroeconomic Indicators, 1984-88
(In percent, unless otherwise indicated)
Source: Végh (1992, pp. 684-85).
1984q1 1985q1 1986q1 1987q1 1988q1
0
500
1000
1500
2000
2500
3000
00
1984q1 1985q1 1986q1 1987q1 1988q1
-10
-5
0
5
10
15
-10
0
Real GDP Growth rate (4-quarter change)
Devaluation rate
Inflation
47
Figure 10.8bArgentina: Macroeconomic Indicators, 1984-88
(In percent, unless otherwise indicated)
Source: Végh (1992, pp. 684-85).
1984q1 1985q1 1986q1 1987q1 1988q1-14
-12
-10
-8
-6
-4
-2
0
2
-14
Fiscal balance (in percent of GDP)
1984q1 1985q1 1986q1 1987q1 1988q10
500
1000
1500
2000
2500
3000
3500
0
Nominal lending rate
48
Figure 10.8cArgentina: Macroeconomic Indicators, 1984-88
(In percent, unless otherwise indicated)
Source: Végh (1992, pp. 684-85).
1984q1 1985q1 1986q1 1987q1 1988q170
80
90
100
110
120
130
140
100
701984q1 1985q1 1986q1 1987q1 1988q1
0
500
1000
1500
2000
0
Trade balance (in millions of U.S. dollars)
Real effective exchange rate (1985q1 = 100)
Real wage (1985q1 =100)
49
Israel (July 1, 1985) Figure 10.9.
50
Source: Cukierman (1988).
Figure 10.9aIsrael: Macroeconomic Indicators, 1984-87
(In percent, unless otherwise indicated)
1984q1 1985q1 1986q1 1987q135
40
45
50
55
60 Tax revenue (in percent of GDP)
1984q1 1985q1 1986q1 1987q1-10
0
10
20
30
40
50
60
70
80
0
-10
Devaluation rate
Inflation
51
Source: Data on the fiscal deficit are from Liviatan (1988). The nominal lending rate is taken from Végh (1992, p. 688).
Figure 10.9bIsrael: Macroeconomic Indicators, 1984-87
(In percent, unless otherwise indicated)
1984q1 1985q1 1986q1 1987q1-15
-10
-5
0
5
-15
Fiscal balance (in percent of GDP)
1984q1 1985q1 1986q1 1987q10
200
400
600
800
1000
1200
0
Nominal lending rate (annual basis)
52
Source: Cukierman (1988).
Figure 10.9cIsrael: Macroeconomic Indicators, 1984-87
(In percent, unless otherwise indicated)
1984q1 1985q1 1986q1 1987q195
100
105
110
115
120
125
130
135
100
Real wage (1978 = 100)
1984q1 1985q1 1986q1 1987q1-4000
-3000
-2000
-1000
0
1000
-4000
Trade balance (in millions of U.S. dollars)
53
Brazil (February 28, 1986) Figure 10.10. Figure 10.11.
54
Source: Modiano (1988).
Figure 10.10aBrazil: Macroeconomic Indicators, 1985-87
(In percent, unless otherwise indicated)
Mar85 Sep85 Mar86 Sep86 Mar8790
100
110
120
130
140
150
100
Industrial production index (1981 = 100)
Mar85 Sep85 Mar86 Sep86 Mar87
-5
0
5
10
15
20
25
0
-5
InflationNominal wage growth
55
Source: Modiano (1988).
Figure 10.10bBrazil: Macroeconomic Indicators, 1985-87
(In percent, unless otherwise indicated)
Mar85 Sep85 Mar86 Sep86 Mar87
1
2
3
4
5
6
7 Unemployment rate
Mar85 Sep85 Mar86 Sep86 Mar87
0
5
10
15
20
0
Growth in M4
56
Source: Modiano (1988).
Figure 10.10cBrazil: Macroeconomic Indicators, 1985-87
(In percent, unless otherwise indicated)
Mar85 Sep85 Mar86 Sep86 Mar870
5
10
15
20
25
0
Monthly deposit rate
Mar85 Sep85 Mar86 Sep86 Mar870
500
1000
1500
0
Trade balance (in millions of U. S. dollars)
57
Figure 10.11Brazil: Inflation and Price Controls, 1984-98
(Month-to-month percentage changes in consumer prices)
Source: International Monetary Fund.Note: Shaded areas indicate periods during which price controls were in effect.
Cruzado Plan
Bresser Plan
Verano Plan
Real Plan
Jan84 Jan86 Jan88 Jan90 Jan92 Jan94 Jan96 Jan88
-20
0
20
40
60
80
100
120
0
-20
58
Mexico (December 1987) Figure 10.12.
59
Source: Kiguel and Liviatan (1992b) and IMF.
Figure 10.12aMexico: Macroeconomic Indicators, 1982-89
(In percent, unless otherwise indicated)
1982 1983 1984 1985 1986 1987 1988 1989-10
-5
0
5
10
15
-101982 1983 1984 1985 1986 1987 1988 1989
0
20
40
60
80
100
120
140
0
Devaluation rate
Inflation
Base money growthReal GDP growth rate
Private consumption
60
Source: Kiguel and Liviatan (1992b) and IMF.
Figure 10.12bMexico: Macroeconomic Indicators, 1982-89
(In percent, unless otherwise indicated)
1982 1983 1984 1985 1986 1987 1988 1989-10
-5
0
5
10
-10
Fiscal balance (in percent of GDP)
1982 1983 1984 1985 1986 1987 1988 198960
80
100
120
140
160
100
60
Real exchange rate(1980 = 100)
Real wage (1980 = 100)
Operational basis
Primary basis
61
Source: Kiguel and Liviatan (1992b) and IMF.
Figure 10.12cMexico: Macroeconomic Indicators, 1982-89
(In percent, unless otherwise indicated)
1982 1983 1984 1985 1986 1987 1988 198960
70
80
90
100
110
100
60
Terms of trade (1980 = 100)
1982 1983 1984 1985 1986 1987 1988 19890
3200
6400
9600
12800
16000 Trade balance (in millions of U.S. dollars)
Argentina’s Convertibility Plan (1991-1997)
63
Figure 10.13.
64
Figure 10.13aArgentina: Macroeconomic Indicators, 1991-96
(In percent, unless otherwise indicated)
Source: Central Bank of Argentina and International Monetary Fund.
1991 1992 1993 1994 1995 1996
0
50
100
150
200
00
1991 1992 1993 1994 1995 1996
-10
-5
0
5
10
15
20
-10
GDP deflator growth rate
Growth rate in consumer prices Real GDP growth rate
Real consumption growth rate
Narrow money growth rate
65
Figure 10.13bArgentina: Macroeconomic Indicators, 1991-96
(In percent, unless otherwise indicated)
Source: Central Bank of Argentina and International Monetary Fund.1/ 30-day prime lending rate.
1991 1992 1993 1994 1995 1996
-3
-2
-1
0
1
2
3
-3
Jan94 Jul94 Jan95 Jul95 Jan96 Jul965
10
15
20
25
30
35
40Federal government primary balance(in percent of GDP)
Federal government overall balance(in percent of GDP)
Lending rate 1/
in Pesos
in U.S. dollars
66
Figure 10.13cArgentina: Macroeconomic Indicators, 1991-96
(In percent, unless otherwise indicated)
Source: Central Bank of Argentina and International Monetary Fund.1/ A rise is a depreciation.
1991 1992 1993 1994 1995 1996
55
60
65
70
75
1991 1992 1993 1994 1995 1996
-6000
-4000
-2000
0
2000
4000
6000
0
-6000
Trade balance (in millions of U.S. dollars)
Real effective exchange rate (1990 = 100) 1/
Brazil’s Real Plan (1994-1997)
68
Figure 10.14.
69
Figure 10.14aBrazil: Macroeconomic Indicators, 1990-97 1/
(In percent per annum, unless otherwise indicated)
90q1 91q3 93q1 94q3 96q1 97q385
90
95
100
105
110
115
120
125
100
Industrial output (seasonally adjusted, 1990=100)
90q1 91q3 93q1 94q3 96q1 97q30
1000
2000
3000
4000
5000
6000
7000
0
Source: International Monetary Fund.Note: A vertical line represents the implementation of the third phase of the Real Plan (July 1994).1/ All data are quarterly.
Inflation
Broad money growth
70
Figure 10.14bBrazil: Macroeconomic Indicators, 1990-97
(In percent per annum, unless otherwise indicated)
Source: International Monetary Fund.Note: A vertical line represents the implementation of the third phase of the Real Plan (July 1994).
1990 1991 1992 1993 1994 1995 1996 1997-5
-4
-3
-2
-1
0
1
2
3
4
5
-590q1 91q3 93q1 94q3 96q1 97q3
-2000
0
2000
4000
6000
8000
10000
12000
0
-2000
Total domestic credit growth
Government credit growth
Central government fiscal balance (in % GDP)
Current account balance (in % GDP)
71
Figure 10.14cBrazil: Macroeconomic Indicators, 1990-97 1/
(In percent per annum, unless otherwise indicated)
90q1 91q3 93q1 94q3 96q1 1997q30
0.2
0.4
0.6
0.8
1
1.2
80
90
100
110
120
130
140
150
Source: International Monetary Fund.Note: A vertical line represents the implementation of the third phase of the Real Plan (July 1994).1/ All data are quarterly.2/ 1990=100; a rise is a depreciation.
90q1 91q3 93q1 94q3 96q1 97q3-10000
-5000
0
5000
10000
15000
0
-10000
Overnigth Interest rate (in percent) Real effective exchange rate 2/(right scale)
Nominal exchange rate 2/(left scale)
Nominal interest rate
Real interest rate
Lessons of Stabilization
73
Fiscal adjustment is necessary. In the absence of a permanent fiscal adjustment,
inflation does not stay permanently low. Setting price-based nominal anchors such as
exchange-rate freezes and wage and price controls is not sufficient for inflation stabilization.
Costs of orthodox stabilization depend on the nature of ongoing inflation.
Under chronic high inflation: Nominal contracts continue to exist. If such contracts possess a backward-looking element,
or if the stabilization program lacks credibility, nominal contracts impart inertia to the wage-price process.
74
Under hyperinflation: Such inertia will cease to exist, when domestic currency
ceases to function as the unit of account and wages and prices are changed frequently due to freely determined exchange rate.
In the presence of inertia: Adherence to noninflationary fiscal targets under a
money-based program generates recession on impact; improvement in the current account; slow convergence of inflation to its targeted level.
Under an exchange-rate-based program: real exchange rate appreciates; current account may or may not improve;
75
inflation convergence continues to be slow.
When inertia is absent (typical under hyperinflation): Quick inflation convergence with minimal output costs
may be possible with a credible fiscal program.
Heterodox elements (exchange-rate freeze with income policies) can be useful for credible fiscal program in stabilizing chronic inflation, but they are dangerous to use.
With sufficient commitment to a permanent fiscal adjustment, a suspension of indexation and the adoption of incomes policies can help establish low inflation rapidly.
This may avoid short-run damage to economic activity associated with orthodox adjustment under these circumstances.
76
Danger: program's short-run success tempts policymakers to slide into populism by relaxing fiscal discipline while relying on wage and price controls for inflation abatement.
This path quickly runs into domestic capacity and foreign financing constraints, and is likely to leave the country in worse conditions than before.
Whether well-implemented heterodox adjustment can permanently avoid the output costs of stabilization is less obvious.
Kiguel and Liviatan (1992a) and Végh (1992): Exchange-rate-based stabilization programs, whether
orthodox or heterodox, tend to avoid real output costs on impact, only to undergo a recession later (“boom-recession” cycle).